Monthly Market Commentary - December 2022

The Republicans did not manage to generate the electoral gains which many had expected, and Congress will be divided for the final two years of the Biden administration. Whether the Republicans can disrupt the President’s agenda using their majority in the House of Representatives remains to be seen but it is probably not going to impact markets that materially. No one really sees the scope for significant fiscal policy expansion over the next two years (given the debt issues facing the economy) so there is not really a grand policy plan to be sent off course. Investors have much more to worry about elsewhere as the inflationary concerns start to morph into worries about the economic prospects for 2023. For now, the employment market remains robust, but the lagging nature of this indicator means it does not count for a great deal at this stage.

Things certainly look cheaper than they did at the start of the year, but asset valuations are not where you would generally expect them to be at this stage of the economic cycle. Aside from the fact that valuation multiples could yet fall further, the usual adjustment in terms of earnings has not happened yet. That combination of high expectations regarding company profits and valuation multiples which are much lower but still not outright cheap makes us nervous about prospects for the first quarter of next year.

For now, despite periods of optimism that the Fed is going to soften policy in response to some sort of progress on inflation, there is a lot of contradictory data and messaging and it just feels as if there is insufficient scepticism in the markets at the current time. This can be seen in the performance of some of the more cyclical areas of the market in the last month with industrials delivering significant returns to investors. Does this really feel ‘right’ considering the softness in some of the data and the fall in company orders coming through? Perhaps it is reflective of the fact that the US economy remains strong in some areas according to some data points, but that very strength makes progress in fighting inflation all the more difficult.

Christmas lunch in the US can pretty much be a re-run of Thanksgiving, with turkeys again bearing the brunt. Of course, the sheer diversity of the population means there are also (among many others) Mexican, Asian and Caribbean foods enjoyed over the festive period.

A lot of the case for economies avoiding recession and markets performing well is based on the dollar weakening and releasing some of the pressure from the global financial system. The weakening of late has been helpful in reigniting risk appetite but given the persistence of labour shortages and underlying economic strength, it is difficult to see rate rises being less extensive than elsewhere (thereby providing support for the currency). It is true that pockets of value are opening up – think small caps and areas which will benefit from the likely reshoring of supply chains – but it still feels ‘too early’ to add to our US market exposure at this juncture.

It is hard to imagine a much bleaker set of conditions for Europe to have faced this year, yet the market has been pretty strong of late. Indeed, in local currency terms, European equities have held up better than their US counterparts in 2022. The energy situation looks to have stabilised at least for this winter period (though challenges do lie ahead) and almost ironically, the continent’s large energy companies have been some of the big winners this year.

The ECB has on several occasions stated that rate rises will continue (Lagarde has said inflation probably has not even peaked yet) and it does not really have much choice to proceed with policy tightening given how high inflation currently is. Any further weakening of the currency (engendered by increasing rate differentials with other countries/regions) would merely compound this problem, but there are probably significant limits on how far this can go in practice, given the state of the economy. Again, there is no easy way out here.

The prevailing conditions make quality equity income in Europe an interesting idea. As is the case in other geographies, there are plenty of businesses which are offering stable cash flows and high dividends as markets navigate the considerable uncertainties. However, as in most other regions, corporate bond yields have now moved ahead of dividend yields which poses challenges for income paying equities. Where the investment case has been solely based on dividends there is now an alternative on the scene, but it also makes those equities relatively more attractive as the opportunity cost of holding non-income paying names is increased. As the economic storm clouds gather, there would seem to be worse places to hide than quality names which the European large cap space has plenty of, whether it be in healthcare, industrials or consumer staples. You have to be careful where you look in the income space however, cyclical names with high dividend yields could prove to be value traps in 2023 and the European financials still come with a significant health warning.

Europe is a rich source of traditional festive foods. From fresh fish in Prague, biscuits in Belgium, cold rice pudding and almonds in Copenhagen to a seasonal smorgasbord in Sweden, there is a bewildering array of dishes which get an extra special twist at Christmas time.

Overall, the balance of arguments points to having some select European exposure but the valuation attractions relative to the US are weakened when adjusted for sector biases and skews. Europe is neither cheap nor expensive compared to many global peers and the prospects for 2023 would suggest maintaining our current allocations at these levels is sensible.

There have been few winners in the equity space this year, but after a long period of underperformance, Latin American equities have enjoyed an excellent time in 2022. The region has managed to outperform broader emerging markets by an astonishing 40% in dollar terms but remains off many investors’ radars. Latin America used to be a significant part of the emerging market indices but now constitutes only around 10% and is only 1% of most world indices – despite contributing 5% of global GDP. The rise of Asia and the growth style investing over the last decade has certainly made a contribution to this imbalance but there are reasons to suppose there could be something of a reversal underway.

The over-reliance of the region on commodities has historically acted as a negative in the minds of investors, but there is clearly scope for this becoming a positive as sectoral and style preferences switch. If China does open up, Latin America may well be an interesting way of playing the increased demand. Then we have the trends towards reshoring and the adjustment of global supply chains which will probably make countries such as Mexico more attractive as manufacturing bases. A lot of the pain of rate rises to deal with inflation has already been endured by nations such as Brazil and the demographic profile is much more attractive than in other regions. Not least, the region offers a degree of additional diversification to the non-developed market allocation in portfolios. Not least, the region offers a degree of additional diversification to the non-developed market allocation in portfolios.

Yes, the politics is less than ideal in many countries, but this is a problem confronted in other regions. With valuations around half those in the Asian emerging markets space this would appear to be more than fairly reflected in prices. We are never seduced by cheap prices at the expense of true value assessment but at seven times forward earnings, things do look very cheap. A recession in many countries next year might not be kind to the region given its commodities and financials skew but an economic downturn is not going to be kind to those other areas which are more expensively valued.

For a truly eccentric festive food experience, head to Oaxaca in Mexico. December 23 is the date of the Night of the Radishes where sculptures of radishes are made in the town. Wild animals and the Virgin of Guadalupe are subjects of this unusual craft. Presumably the creations are eaten after the event.

We are not making a specific allocation at the present time but are actively discussing the idea as a means of bringing something different to higher risk portfolios.

As 2022 draws to a close, it is the energy sector that has led the way in terms of performance. The space has become increasingly difficult for active managers to avoid and with valuations remaining attractive, it is perfectly reasonable to wonder whether there could be more joy to come in 2023. There is certainly more love for the sector and the narrative seems to be changing. For many, these are no longer companies with stranded assets and relics of the ‘old economy’. Instead, oil and gas companies could hold the key to accelerating the energy transition.

Firstly, shareholders are pushing management to deliver change, with the number of votes in favour for climate-related proposals rising significantly over the last decade. Clearly, those at the top are listening, with the amount of capital expenditure into new fossil fuel projects continuing to wane. In previous cycles, capital expenditure has followed higher oil prices, but not this time (at least, not yet). Finally, the breadth of operations of oil and gas firms appears to be underappreciated by the market. Most large cap European firms have subsidiaries in hydrogen, biofuel, battery storage, solar and wind. Indeed, these firms are some of the largest generators of renewable energy in the world.

Previously, there has been some criticism around the allocation of capital towards renewables projects by shareholders of oil and gas firms. These tend to earn far lower returns on capital than fossil fuel projects, particularly when oil prices are buoyant. However, renewable projects are looking more attractive, due to higher electricity prices. Renewables also secure a future for those companies, who eventually will run out of oil and make them behave in a more utility-like manner, potentially attractive to prospective shareholders down the line.

We retain exposure for higher risk investors and continue to debate the case for owning the sector more widely.

As we have discussed, the weakening of the US dollar could become a major theme for investors in 2023. If that does play out we could see a reversal of the fortunes of those asset classes that have suffered this year at the hands of dollar strength. One such area is emerging market debt. As a reminder, a significant portion of debt in emerging markets is priced in US dollars, meaning a stronger dollar equates to higher interest payments from the domestic currency. It therefore holds that a weaker dollar could be a fillip for those same sovereigns and corporates.

The inflation picture is also much more nuanced than in the major developed market economies. Many emerging markets now appear to be on markedly different interest rate paths, with some even cutting interest rates to boost activity. Yields on hard currency emerging market bonds also look attractive, relative to both history and other areas of the fixed income market. This remains the case, despite a rally in the sector, on the back of data points suggesting that we could be seeing a slowdown in the pace of US inflation and ensuing weakness of the dollar.

It has been a bruising year for many in the sector, with JP Morgan estimating outflows of $86 billion year-to-date, four times the amount that was sold during 2015’s Taper Tantrum. Issuance has been equally disappointing, with liquidity drying up and adding to the distress for some corporates.

Back to Mexico, Christmas is celebrated from 12 December to 6 January. The final day of celebrations is known as Día de los Reyes Magos, or day of The Three Kings.

On this day families eat Three Kings Cake, which has a figure of the baby Jesus inside.

Should issuance remain subdued, and the dollar continue to weaken, we could see a reversal in the fortunes of the asset class. We do not currently have direct exposure, having taken the decision to remove our position earlier in the year. However, it is an area that we continue to debate.

Biotechnology enjoyed a moment as one of the darlings of the stock market in 2020. Previously viewed as a niche topic and sector, biotechnology was thrust into the spotlight as we learned that the Covid-19 vaccines produced by Pfizer and Moderna use mRNA technology. However, the sector has not been immune to the deteriorating macroeconomic outlook for growth companies. Since November 2021, biotechnology stocks have floundered as central banks have aggressively hiked interest rates in the fight against stubborn inflation, causing investors to favour established companies with reliable cash flows. Investors view biotechnology companies as young and striving to pioneer new science and therefore the furthest thing from stable and reliable. This view has caused a cloud of negative sentiment over the sector but does of course overlook some of the larger-cap commercial names in the space.

While broadly the earlier-stage part of the biotechnology sector looks to be battling macroeconomic headwinds, several biotechnology managers have told us that they are beginning to detect a slight improvement. Fundamental news flow for the sector has become more positive.

Earnings season for biopharmaceutical companies has been the best across all the healthcare verticals, which indicates the non-discretionary nature of pharmaceutical drug spending as well as an industry well insulated from the inflationary and supply-chain issues seen elsewhere. Many of the preeminent biotech companies have both strong drug candidate pipelines and winning drugs already on the mark. Importantly, the FDA remains constructive and relatively accommodating towards the biotechnology space and we see major new product cycles and opportunities on the horizon, particularly around solutions for obesity and dementia.

Innovation is a key driver of the biotechnology sector, but it tends not to be a feature we look for on our festive dinner table. However, this has not stopped a trend of offbeat dishes adorning some eccentric festive spreads. Often, these recipes eventually make their way into the mainstream.‘Turducken’ is a good example, the dish consists of a deboned chicken stuffed into a deboned duck, further stuffed into a deboned turkey. Rather confusingly vegan versions of the dish have sprung up over the past few years.

There is exposure to a select number of biotechnology companies within our core portfolios via broad investment in the healthcare sector. We have selected experienced managers to cherry pick stocks that look set to be winners in the space given our view that the chasm between companies that will perform strongly and those that will suffer will widen as the macroeconomic environment becomes tougher. 

Companies that sit in the clean economy space have sold off quite dramatically since late 2021, similar to biotechnology stocks. Given that the majority of names in the clean economy space are viewed as growth companies, monetary tightening is not a positive for stocks in this sector.  We have seen a lot of the names across the sector behaving as if they are very cyclical and selling into standard industrial and auto markets which are pricing in a recession however, this fails to give these companies credit for positive structural growth tailwinds which they are set to enjoy for decades.

Near-term macroeconomic conditions for the sector clearly remain challenged by the ongoing global supply chain disruption and rising inflation. Despite broader macroeconomic challenges, demand for the services of the companies involved in the energy transition continues to grow due to both the shift to sustainability and the incentive to limit the use of inputs. Those businesses with leadership positioned to capture this enjoy the opportunity for decades of structural growth. Those with the quality to capture this while managing external pressures associated with supply chains, interest rates and geopolitics represent attractive investment opportunities, at considerably lower valuations than we have seen for some time.

The Inflation Reduction Act (IRA) signals a commitment from the US to support the shift to a cleaner economy. Prior to IRA, renewables were already cheaper than hydrocarbon-based energy now, on a like for like basis, renewables look even more attractive than hydrocarbons despite higher electricity prices. While the economics of decarbonisation made sense before the act, the tailwind has been supercharged by the IRA. Although we cannot expect huge near-term volume numbers but rather gradual uptick as these are 10-year tax credits. Investing in the environment sector is a long-term theme not a short-term, tactical play.

Although not (usually) edible, Christmas crackers are a staple on many festive tables. However, many crackers contain non-recyclable materials that ultimately end up in a landfill. Enter the rise of eco-friendly Christmas crackers. A number of companies, from independents to high street names, are now producing crackers made from recycled, plastic-free materials. Have yourself a sustainable little Christmas!

We continue to include this theme within portfolios. The investible universe for clean economy funds is continually expanding as the whole economy needs to decarbonise and we are clearly just at the beginning of this journey. There are a number of interesting areas that are not yet investible (such as green steel, green aviation) that over time may eventually be part of the universe.